The spot exchange contract
The decision by Saudi Fertilizers Corporation (SFC) to make a commitment of a single payment for the purchase of a ship would be based on the spot or current exchange rate of the Riyal against the Yen. This option which binds the two parties of the contract requires the importer (SFC) to buy an amount of the foreign currency Japanese Yen (known as Yen) (Yen) equivalent to the price of the ship on the settlement date. The terms of the spot agreement are set on the trade date but the actual exchange of payment for the commodity takes place on the settlement date, two days after the contract is entered into (Hull).
The forward exchange contract
On the other hand, the second option of spreading the payment over a six month period is a forward contract. Unlike the foreign exchange spot, the principle amount, fixing date, forward exchange rate and forward date of the forward exchange contract are agreed on during the trade date. According to Canabarro, Picoult and Wilde (117), the commitment to make payment in the Yen for the purchase of the ship creates a Yen liability exposure to foreign exchange risk. And in case the Yen appreciates during the six months, the Saudi Riyal cost of the ship will increase. Due to this uncertainty in the future exchange rates, it is advisable for SFC to lock in the purchase cost of the ship in Yens, by entering into a 6 month forward contract to purchase Yens equivalent to the value of the ship in Riyals on the date when the supplier is issued and accepts the purchase order.
Setting the contract price
The currency market demand and supply is used while computing the spot exchange price. On the other hand, the price of the contract is dependent on the prevailing spot rate at the time of trade. Therefore, due to the reliance on the market forces of demand and supply for the pricing, the spot contract is limited by the unpredictable movements of the rate of exchange. Primarily, the exchange rate differences are subject to a country’s economic situation, government intervention and monetary and fiscal policies. Additionally, the fluctuations can result due to foreign and domestic interest rate differences, balance of payments, and inflation rates. Although it is the simplest option for immediate execution, SFC’s reliance on the spot exchange contract is a risky option as cash flows are exposed to the risk of unfavorable fluctuations in the foreign values (Hakala and Wystup).
Conversely, for the forward contract, the agreed upon exchange rate is set against the prevailing spot exchange rate two days before the delivery date. Reference is made on the spot exchange rate from the market statistics. Pricing of the forward rate is determined by the spot rate on the booking date, in addition to an adjustment of ‘forward points’ that caters for the interest rate variations between the two countries involved. Thus both parties to the contract benefit depending on the interest rate differentials of their countries (Canabarro, et al., 123).
Benefits of a forward contract
Parties to a forward contract also enjoy the benefit of voiding the contract at any time before the maturity or delivery period. This option can be affected when the fundamental reason that had required the parties to set the future exchange rate in the forward contract does not exist anymore. Because the policy of ‘marking to market’ will apply for such unexpected voiding of the contract, the buyer and the seller may incur some losses or profits. The unforeseen changes in conditions result due to the volatility of the currency markets and fluctuation of the underlying currencies (Fama 319).
According to Hakala and Wystup other benefits accruing to the parties of a forward exchange contract include, the term and the amount of the contract can be determined by the parties and is not limited; the maturity dates are also flexible pending the agreement by the parties; the contract is self-relating and does not need an association to oversee the agreement and transfers; the contract offers a full hedge; the contract accommodates all currencies; and the settlements occur through delivery.
Another aspect of hedging strategies is the measurement of their effectiveness. The provisions of ASC 815 require that a transaction ought to adhere to a certain criteria so as to be classified as hedge accounting. Primary in the criteria is the initial arrangement for a formula that measures hedge effectiveness and ineffectiveness. Once the assessment formula has produced the estimated gains and losses, the reporting entity should ensure that they are not transferred to a future period, but instead end up being reported in the evaluation period. Thus, for the SFC case, ASC 815 requires that assessment reports should exclude in their hedge effectiveness assessments the forward contract’s fair value portions attributed to spot-forward differences including spot exchange rate and forward exchange rate differences (Fama 338).
Consequently, on the basis of current spot rates adjusted for time value, the reporting entities should compute the cash flows estimate of future transactions. The effectiveness will be assessed by conducting as comparing the changes in the fair value of the contract with the changes in changes in the forecasted cash flows. From the above analysis, it is advisable for SFC to use the forward exchange contract to mitigate its exposure to foreign exchange risk during the purchase of the ship.
Canabarro, E., Picoult, E. and Wilde, T., “Analysing counterparty risk.” Risk Magazine, 16.19 (2003): 117–122.
Fama, E. F. “Forward and Spot Exchanges.” Journal of Monetary Economics. 14.3 , (1984): 319-338.
Hakala, J. and Wystup, U. Foreign Exchange Risk: Models, Instruments, and Strategies. London, UK: Risk Publications, 2002.
Hull, J. Options, Futures, and Other Derivative Securities. 4th ed. Englewood Cliffs, NJ: Prentice-Hall, 2000.